# Schweser Vol2 2PM #101 - Project with a risk of failure

Project A is expected to be valued at 300m in the next five years. The discount rate is 40% There is a 15% probability of failure. The question is: What is the NPV of this project? I understand that we set FV=300 I/Y=40 N=5, calculate for PV, then multiply it with 0.85 (project success probability), and arrive at 47.41m. But Schweser’s solution doesn’t take this probability into account. They simply use the output PV from the calculator(55.78m). Why is it so?

You’re right…I didn’t even see this the first time through it, but the correct discount rate 0.6471, which would yield a value of 40.76…

I thought the exact same thing and wondered why the probability of failure was not taken into account… so if we are given a probability of failure, is it safe to say that we should always adjust the discount rate before calculating NPV and that this was an error on Schweser’s part?

westibbs Wrote: ------------------------------------------------------- > You’re right…I didn’t even see this the first > time through it, but the correct discount rate > 0.6471, which would yield a value of 40.76… Ditto.

Agree. But, i believe 47.41m is not one of the choices though it is close to \$48 M, so i recal without adjustment to failure and end up with one of the answers. Figured it is safe to go with one of the exact answers, but still believe the probability of failure should be included.

westibbs Wrote: ------------------------------------------------------- > You’re right…I didn’t even see this the first > time through it, but the correct discount rate > 0.6471, which would yield a value of 40.76… Hi all Not sure what the question is, if the question is referring to how the discount rate is calculated then I believe it’s as follows. If the question is not about the discount rate then ignore the calc below. Calculated Discount rate = (discount_rate + probability_of_failure) / (1 - probability_of_failure) Calculated Discount rate = (0.40+0.15)/(1-0.15)= 0.6471 See page 86 in the CFA Alt book. Cheers

^ that should be the correct approach according go me. 0.85(npv) would make sense if it were a question from emerging markets. Pvt equity in alternative investments, however, has a formula to adjust the discount rate. But then, schweser hasn’t adjusted it.